Roth IRA Conversions - a Golden Opportunity

By David Chazin

2010 is the start of a new decade, and the government is kicking it off with what many consider to be a very special opportunity. New rules will allow most people (including you at Chevron) the opportunity to convert a traditional Individual Retirement Account (IRA) to a Roth IRA. Normally, this is restricted to people with certain incomes, but in 2010, all taxpayers, regardless of income, can make these conversions.

Roth IRAs can play an important role in retirement planning as they allow for tax-free growth (on post-tax dollars) and withdrawals and are NOT subject to required minimum distributions (RMDs) during the account owner’s lifetime. (Conversely, traditional IRAs are subject to RMDs, because contributions are made with pre-tax dollars and grow tax-deferred, then taxes are paid on the distributions). Clearly it is important to consider the advantages and disadvantages of the new conversion rules.

A summary of the new rules
1. You can convert your traditional IRA to a Roth IRA regardless of your income (although contributions will remain subject to income limits).
2. Any assets converted from a traditional IRA to a Roth IRA are treated as taxable income for the year of the conversion.
3. If you convert your IRA to a Roth IRA in 2010, you have the option to pay the federal income tax due in two equal installments during 2011 and 2012. It’s a one-time opportunity that won’t be available for conversions after 2010.
4. You can convert just part of the assets in your traditional IRA.
5. You have the option of rolling over old 401(k) or 403(b) accounts into a Roth IRA.

What issues need to be considered?
Before converting your traditional IRA to a Roth IRA, you should think about some of the following issues:
1. Paying income taxes: Can you pay for the conversion? Funds from outside your old 401(k) or IRA should be earmarked for the additional tax liability. Using the assets you are converting to pay the tax could trigger 10% early withdrawal penalties. Doing so will also reduce the assets eligible for tax-free growth and distributions available through the Roth IRA.

2. Future tax rates: Tax rates today are historically low. The top rate is 35%, compared with rates as high as 94% in the distant past. Since then, top rates have been as high as 91% in 1964, 70% in 1981, and 50% in 1986. Many experts believe that taxes will rise in the future, especially with the increased debt our government has taken on, so incurring the tax liability now may make the most sense.

3. Recent investment losses: Reduced account balances mean lower conversion taxes. Converting reduced IRA balances and paying the taxes now will result in a lower tax burden while allowing those assets to recover in a tax-free account.

4. Adjusted Gross Income (AGI): Converting a traditional IRA or an old 401(k) to a Roth IRA will cause an increase in your AGI and may place you into a higher tax bracket. A partial conversion provides flexibility in determining your AGI.

5. Additional tax considerations: An increase in AGI may cause Social Security benefits to be taxed, result in phase-outs for deductions or personal exemptions, or disallow certain tax credits, among other consequences. Keep in mind that if part of your total IRA balance consists of nondeductible contributions, a portion of those conversions may be non taxable.

6. Investments: Be sure to consider how you invest the assets in your converted Roth IRA knowing that they’ll grow tax-free and how that will affect your overall asset allocation strategy.

7. Future distributions: Roth IRA owners are not subject to required minimum distributions and distributions are generally income tax-free. A beneficiary who is not your spouse would be subject to RMDs, but distributions can be stretched over the beneficiary’s lifetime. Those distributions are generally income tax-free.

8. Your retirement needs: A traditional or Roth IRA can help supplement any shortfall from pensions or Social Security. The potential benefits of conversion are unique to an individual’s age, retirement goals and overall profile. A Roth IRA‘s tax advantages can play an important role in navigating a future made more challenging by potentially higher tax rates and the need to work longer. Converting removes the uncertainty of future tax increases and reducing the uncertainties associated with retirement always makes sense.

9. Changing your mind about the conversion: Roth IRA conversions come with a “do-over” provision called recharacterization, which allows you to convert back to a traditional IRA. You might consider a recharacterization if your investments drop after the conversion, meaning your applicable taxes were higher than they would have been had you waited. People who choose to recharacterize will receive a tax refund on any tax paid on the conversion, or the tax liability will be removed if they have yet to pay the tax. The IRS also allows time for you to evaluate your conversion decision. For example, if you convert any time in 2010, you have until October 15, 2011, to recharacterize. That is because recharacterization can be done up to the due date of your tax return plus extensions.

10. Leaving your Roth to your heirs: When it comes to legacy planning, a Roth conversion may appeal to older individuals with large estates who don’t need a traditional IRA for income. Also consider that assets used to pay conversion taxes will reduce your taxable estate and in turn your estate tax. Your heirs will eventually inherit the Roth IRA from which they can withdraw tax-free income throughout their lives

The Bottom Line
Converting your traditional IRA to a Roth IRA requires thinking about many factors. We’d be happy to sit down with you to review how this would affect your tax liability, answer any financial questions you have, and discuss an overall strategy for your retirement and investments.
Because we work with multiple Chevron employees and retirees, we're very knowledgeable about your various compensation plans and benefit offerings, plus other issues specific to Chevron employees (in addition to the retirement, investment, and estate planning issues everybody faces).

Please contact us at (925) 659-0217 with specific questions or to schedule a time to meet in our San Ramon, Point Richmond or Houston, TX offices. Also, follow us on LinkedIn.

David Chazin, Insight Wealth Strategies and Lincoln Financial Advisors Corp are not affiliated with Chevron.